The Energy Report: Oil prices continued to fall last month.
What happened? Is this a problem of too much shale oil, too little demand
from China or something else entirely?
Keith Schaefer: I think it has a lot to do with increasing shale
production in the U.S. Production resiliency has surprised everyone. It
surprised investors and lenders. It certainly surprised the Saudis. And it
surprised the long oil speculators. We saw that nice pop back up to $60 a
barrel ($60/bbl) after the initial collapse to $40/bbl in December/January.
But as the rig count dropped and oil production failed to decrease, the longs
have gotten discouraged.
The Street has realized that the Saudis are going to keep putting the
pedal to the metal, Canadian heavy oil production cannot be turned off, and
debt-laden producers in the States aren't going to shut down existing
production. We will continue to have excess supply for the foreseeable
future.
TER: If rig counts are not a good indicator of future production,
what signs will signal we are headed for a move up to sustainable prices?
KS: Rig counts have not been an indicator yet. Producers
just keep finding new efficiencies, new technologies, new savings on service
costs that allow them to continue pulling oil and gas out of the ground. The
market has lost confidence in the U.S. Energy Information Administration
(EIA) and the Paris-based International Energy Administration. Those numbers
don't carry the weight they used to carry. In the end, we might just be waiting
for time and recounts. [Note: Since this interview was conducted, the
EIA has come out with a new methodology for oil production reporting, and
revised production in the U.S. downward by 100,000 barrels per day (bbl/d).]
TER: That explains the uncertainty on the supply side. What factors
are impacting oil prices on the demand side? Chinese market news? The looming
Federal Reserve interest rate increase? What are you watching to determine
when that excess production could be absorbed?
KS: Higher interest rates would put some discipline into this oil
bucket. The main reason oil prices are so low is because of the zero-interest
policy. This industry lives and dies on debt. If debt was all of a sudden
6–8% and the banks were firm on their covenants, there's no way the U.S.
would have had anywhere near the growth in production we've seen. But when
debt is free and you have the U.S. dollar as a carry to boot, it's basically
free production.
So, yes, I am watching interest rates, although I don't know that a nudge
from essentially zero to 3% is going to make much difference. I think
interest rates would have to rise to at least 5% before you see debt get
reined in and the lenders get a lot more disciplined with the producers.
TER: You have been writing about the profit margins in the
refiners. Is that a safe way to weather this storm?
KS: It was up until recently. We've seen a stunning pullback in the
crack spread in the last 10 days, down about 40% from where it was in
January. We sold out of our Valero
Energy Corp. (VLO:NYSE) position for a very small loss just to sit and
wait out the volatility. Gasoline inventories have been up, and prices have
taken it on the chin hard. I still own refineries as my biggest position in
the energy sector. My two largest positions are the refinery trade and cash,
and cash dwarfs the refinery trade. I'm waiting for some new trend to develop
that we can start to play. I know it's hard for retail investors. Often the
hardest thing to do is nothing. My non-positions may mean I will miss the
first 15% of the rebound, but I will be ready to jump in with cash when it
does turn.
TER: Once oil prices start to turn, what sectors will start to look
attractive first?
KS: If we saw oil turning around to the positive, we'd immediately
look to the producers. Really, you just want to own the best names.
In the U.S., that might be Matador
Resources Co. (MTDR:NYSE). In Canada, it's Raging
River Exploration Inc. (RRX:TSX.V) and Whitecap
Resources Inc. (WCP:TSX.V) on the junior/intermediate side. These
companies work at very low oil prices—surprisingly low prices. Canadian
companies are way better off because the Canadian dollar has cushioned the
blow for producers. Sadly, it's hurt consumers because the price of gasoline is
$0.25/liter higher than what it should be if the Canadian dollar were still
at $0.90. But it has saved the producers' bacon.
TER: Other than the exchange rate, what makes Raging River and
Whitecap the companies to watch?
KS: Raging River is on everybody's list. CEO Neil Roszell and his
team have great cost discipline. The company's Viking assets in Saskatchewan
are relatively shallow. The company has been able to reduce oil well capital
expenditures from $900,000 ($900K) per well to $700K per well. They pay out
in 18–20 months at these low prices.
At Whitecap, Grant Fagerheim and his team have done a great job putting
together a whole suite of assets that a year ago all had less than one-year
payouts. That's really unusual. Most companies that have more than one play
have one lead with a payout of a year, whereas Fagerheim has put all of his
plays together like that. That's amazing. When things turn around, those are
the stocks you want to go buy.
TER: It looks like Whitecap is still paying a dividend?
KS: Yes, it is still paying a dividend, and its sustainability
ratio is pretty close to 100%. That means the money the company is putting
into the ground drilling, and how much it's paying out in dividends, is more
or less its cash flow. Obviously, you want your cash flow be greater than
your expenses. Oil only has to go up marginally for that to happen. That's
pretty unique in the business today.
TER: You have written about the prospects for Canadian liquefied
natural gas (LNG). What companies should investors be watching in that
sector?
KS: LNG prices around the world are quite low right now. Costs are
lower, and there's lots of supply coming onstream, but big companies like Royal Dutch
Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and Exxon Mobil
Corp. (XOM:NYSE) have invested heavily in LNG projects in British
Columbia because they know when oil prices come back, another huge disconnect
from gas will occur.
Right now, oil and gas are actually quite close in price per British
thermal unit (Btu). But when oil was at $100/bbl, gas was $3/bbl, and that
spurred a lot of demand for gas. Companies like Shell look at 20-, 30-, even
40-year cycles. And they like what they see.
The math on oil is quite simple. There are only 4 million barrels a day (4
MMbbl/d) of excess capacity today, and I would suggest it's even less than
that. We lose 4 MMbbl/d in natural decline per year, and no one is drilling
for new oil at these prices. So it won't take long for the market to come
back into equilibrium. When oil is once again much more expensive than gas,
you'll see demand for gas rocket right back up. I think that's what these big
guys are seeing, and why they are still moving forward in a big way on gas
projects. They understand that you have to work the cycle two or three times
over the life of your asset, and you're going to make most of your money at
the top and not very much at the bottom. They see today as the bottom that
sets them up for success at the top of the next cycle.
I was a real bear on natural gas earlier this year, and both natural gas
stocks and natural gas prices hung in way better than I expected. We're not
at the $7 per billion cubic feet we were at last year or two years ago. But
structural demand has kept pace. The North American gas market is now
incredibly leveraged to one play, the Marcellus.
In Canada, the Montney is increasing production. If it had more pipeline
capacity, it could produce quite a bit more, but it still pales compared to
the Marcellus. A lot of people are watching Marcellus production very closely
because natural gas is a binary trade in North America. Until the production
of the Marcellus and the Utica (underneath the Marcellus) peaks, gas prices
are going to stay under pressure.
But as soon as the Street has any confidence that Marcellus/Utica
production has peaked, get long gas, because structural demand has
increased so much. LNG exports could occur as early as October out of Cheniere
Energy Inc. (LNG:NYSE.MKT) in Louisiana. Mexican exports of gas have been
much higher than I expected to see this year. I'm not rushing out to buy any
gas stocks, but that market has my attention more now than it ever has in the
past.
LNG in Canada is a bit of a binary trade right now with the Canadian
election coming up Oct. 19. If a left-wing New Democratic Party (NDP)
government gets in, I think LNG is going to be dead for six months to a year
while LNG policies are hashed out. But if the right-wing Conservatives get
back in, then I think Shell, in particular, but also Petronas, will probably
move forward. The companies that will benefit first are the construction
companies, like Petrowest Corp. (PRW:TSX) and Entrec
Corp. (ENT:TSX.V), along with bigger companies like Aecon Group
Inc. (ARE:TSX) and Bird Construction Inc. (BDT:TSX), which build the
infrastructure for the pipelines. On the LNG side, that's where I think
investors should be looking, and making sure their shopping lists are ready.
TER: If the majors are planning how they are going to replace
reserves when the market turns, does that mean that we are in store for more
merger and acquisition (M&A) activity?
KS: Oh, yes. You'll definitely see it, but I think it will get done
in a much more disciplined context. You will see quite a rush to bring on
more production, but I think the lenders are going to be more disciplined on
debt:cash flow ratios.
The prices for M&A actually haven't come down very much, despite quite
a bit lower commodity prices, which really surprises me. We haven't had a big
deal get done in the last month, when oil prices really took the tank.
There's so much private equity money sitting on the sidelines waiting to
pounce into this market that it is creating way more optimism on the seller's
side than is warranted by the prices we're seeing today.
I really thought we were going to see an unbelievable amount of M&A in
Q4/15. Now, I'm just not so convinced, because there is still a lot of hope
out there. The financial community is known to be pretty lenient in foregoing
its credit terms. I think, sadly, we're going to see a lot of these zombie
companies hang on for longer than they deserve to.
Another challenge that will face the industry when the oil price comes
back is the gap in energy services that has developed. We have lost a lot of
technical talent on the services side. I don't know how quickly that's going
to come back. A lot of rigs have been sold, and they're not going to be easy
to get back. And talent is not going to be easy to get back. So if this does
turn around in a hurry, that's going to exacerbate costs. The service side
should benefit quite a bit.
TER: Are there service companies that you follow?
KS: There are a lot. As the service industry turns, first we will
see an increase in volume, and then an increase in margin. Companies like Canyon
Services Group Inc. (FRC:TSX) on the fracking side could benefit.
Fracking sand companies like Emerge
Energy Services LP (EMES:NYSE) and U.S. Silica
Holdings Inc. (SLCA:NYSE) will have lots of leverage. They all have small
share floats. The amount of sand being used actually hasn't dropped that
much. So if there was a rebound and there was an increased demand for sand,
those stocks would do quite well. They're highly leveraged to an increase in
activity.
Service companies like Gibson Energy Inc. (GEI:TSX) had their stocks crushed
just as much. They would probably have the first big bounce. Canadian
Energy Services and Technology Corp. (CEU:TSX), Secure
Energy Services (SES:TSX) and Gibson would have pretty massive turnarounds.
Then the smaller guys would follow suit a couple months later, if the sector
was still moving up.
TER: What words of wisdom do you have for energy investors trying
to do the right thing for their portfolios during a difficult time?
KS: The more cash you have as we're going into the very choppy
months of September/October, the better. On the Canadian side, you really
want to be cautious over the next couple of months until you see what's going
to happen with that election.
TER: Thank you Keith.
Keith Schaefer is editor and publisher of the Oil
& Gas Investments Bulletin, which finds, researches and profiles
growing oil and gas companies that Schaefer buys himself, so Bulletin
subscribers know he has his own money on the line. He identifies oil and gas
companies that have high or potentially high growth rates and that are
covered by several research analysts. He has a degree in journalism and has
worked for several Canadian dailies but has spent over 15 years assisting
public resource companies in raising exploration and expansion capital.
